The dollar's slaughter has been well telegraphed, as US rates have marched lower due to a combination of persistently low inflation and as some market participants deem potential recessionary conditions imminent.
What if I was to tell you that the opposite could be imminent? Would you be interested in reading further?
In the past, we have also documented on Macro Man in a commodity catch-up post that the markedly strong move in copper and other base metals in the past has usually hinted at strong economic growth and inflation.
These two factors being at odds for what seems like an eternity (in trading terms) leads to my belief that we will eventually hit a make or break moment will the divergence between these two correlated asset classes will mean revert.
Let's get into it.
So I am claiming that we probably have a significant bounce in the dollar in the making...
A few drivers that can potentially make this bounce happen:
1) The big one to me is the break of correlation between inflation/inflationary products. Using copper as a proxy, we can see that the returns of the two products show a clear correlation - obviously, this makes sense vis-Ã -vis economic intuition; the R-squared is a bit low as copper is naturally more volatile compared to breakevens.
We have seen a huge run-up in copper but breakevens have sputtered. I see this correlation maintaining and the gap between the two closing. If we have a rise in breakeven inflation going into year-end, then that means there would be a corresponding move in rates, and thus a notable bounce in the dollar as well.
2) That transitions us to point number two - rates. I'm specifically looking at fed funds futures where we are pricing in a tad more than a 25bps hike by January of 2019. Whatever outcome materializes in the US economy, it seems to me that the fed funds curve is too flat and investors are being too cautious.
Like I said, whatever the outcome may be, PnL is path dependent - you will undoubtedly have rhetoric, communication, and expectations to shift (at the very least during pockets of time from now till 2019) where we see both a drop in fed fund futures across the curve as well as a steepening of the fed funds curve.
That occurrence should coincide with a dollar bounce.
3) Okay, we've talked about inflation and rates from a correlation perspective. What about the fundamentals? Inflation has been stubbornly low, but there are signs of an uptick bubbling below the surface.
Average weekly hours worked has also spiked. Even if wages fail to materially increase, the increase in hours worked should lead to extra total wage income.
The magnitude of the increase will be amplified by years of QE.
Again, like most markets, corresponding moves aren't always immediately and 1 to 1 in nature. It can take a bit before the market comes to an epiphany - that "Ah ha!" moment.
4) The US economy and the global economy seems to be doing okay. Everything seems safe-ish.
Looking at some very basic metrics such as GDP and unemployment here. The growth has continued from then till now, and we are still on track for additional growth. I get it. We expected an explosion of growth after Trump and that hasn't really happened, but things are not worse than they were two years ago! Yet rates and USD in real terms have round-tripped back where we were two years ago.
5) Another trigger would come from the rest of the world. With FX these last few years being a game of lemmings where countries deviate little from the lead of the United States. It might be time to wonder if we are due for a pick-up of catalysts and rhetoric from other countries concerning the strength of their currencies, as well as disappointments from other central banks regarding their hawkish policies.
Europe and China need to be the main culprits. With that said, many in the rest of the world are involved as well.
First China: they recently got rid of the deposit requirement for FX forwards - something they implemented two years ago to slow the devaluation of RMB. This should make it less expensive for companies and investors to buy dollars while selling the yuan. And guess what? The dollar is cheaper now.
Although the change itself is mostly symbolic and not necessarily a force to be reckoned with, it can potentially serve as a canary in the coal mine for future attempts to stem RMB appreciation.
Europe growth has been very strong - and the FX market has responded accordingly. This is a bit of a question mark for me - interest rate futures' pricing is hovering around record lows for a ECB rate hike by June 2018.
If we get some convergence there, that would mean Euro sells off a bit - helping dollar bounce - but in terms of the intricacies of the ECB at this point in time? *Shrug*
Now the rest of the world. The most dollar sensitive countries are obviously in EM. Many of the Asian countries have already shown signs of intervention against their strengthening currencies as they start to accumulate reserves, specifically in dollars.
Exhibits below for your entertainment:
Eventually, dollar shorts should notice. Again, I've noticed in the past that these trades in these currencies often preceded moves in US rates. Canary number two for the aviary, anyone?
By the way, shout out to fellow contributor Shawn who shared an article articulating what is beginning to transpire across the world - you can read all about it via the link below.
https://www.cfr.org/blog/few-words-dollar
With that in mind, it has run up a lot. If the dollar does bounce, we are probably going to get a shake out of the weak hands and late comers to the trade.
Cocoa and sugar - both bottoming nicely. I still maintain sugar might be a tad too early. Cocoa looks really good and I strongly believe it can rip. I even did some work to do a seasonality adjustment. Below is the inverse inventory on a seasonally adjusted basis vs price. Please excuse the poorly drawn arrows.
Anyways, have a good week guys.
What if I was to tell you that the opposite could be imminent? Would you be interested in reading further?
In the past, we have also documented on Macro Man in a commodity catch-up post that the markedly strong move in copper and other base metals in the past has usually hinted at strong economic growth and inflation.
These two factors being at odds for what seems like an eternity (in trading terms) leads to my belief that we will eventually hit a make or break moment will the divergence between these two correlated asset classes will mean revert.
Let's get into it.
So I am claiming that we probably have a significant bounce in the dollar in the making...
A few drivers that can potentially make this bounce happen:
1) The big one to me is the break of correlation between inflation/inflationary products. Using copper as a proxy, we can see that the returns of the two products show a clear correlation - obviously, this makes sense vis-Ã -vis economic intuition; the R-squared is a bit low as copper is naturally more volatile compared to breakevens.
We have seen a huge run-up in copper but breakevens have sputtered. I see this correlation maintaining and the gap between the two closing. If we have a rise in breakeven inflation going into year-end, then that means there would be a corresponding move in rates, and thus a notable bounce in the dollar as well.
2) That transitions us to point number two - rates. I'm specifically looking at fed funds futures where we are pricing in a tad more than a 25bps hike by January of 2019. Whatever outcome materializes in the US economy, it seems to me that the fed funds curve is too flat and investors are being too cautious.
Like I said, whatever the outcome may be, PnL is path dependent - you will undoubtedly have rhetoric, communication, and expectations to shift (at the very least during pockets of time from now till 2019) where we see both a drop in fed fund futures across the curve as well as a steepening of the fed funds curve.
That occurrence should coincide with a dollar bounce.
3) Okay, we've talked about inflation and rates from a correlation perspective. What about the fundamentals? Inflation has been stubbornly low, but there are signs of an uptick bubbling below the surface.
Wage growth has been tepid but a couple indicators show continued increases overall.
The magnitude of the increase will be amplified by years of QE.
Again, like most markets, corresponding moves aren't always immediately and 1 to 1 in nature. It can take a bit before the market comes to an epiphany - that "Ah ha!" moment.
4) The US economy and the global economy seems to be doing okay. Everything seems safe-ish.
Looking at some very basic metrics such as GDP and unemployment here. The growth has continued from then till now, and we are still on track for additional growth. I get it. We expected an explosion of growth after Trump and that hasn't really happened, but things are not worse than they were two years ago! Yet rates and USD in real terms have round-tripped back where we were two years ago.
Europe and China need to be the main culprits. With that said, many in the rest of the world are involved as well.
First China: they recently got rid of the deposit requirement for FX forwards - something they implemented two years ago to slow the devaluation of RMB. This should make it less expensive for companies and investors to buy dollars while selling the yuan. And guess what? The dollar is cheaper now.
Although the change itself is mostly symbolic and not necessarily a force to be reckoned with, it can potentially serve as a canary in the coal mine for future attempts to stem RMB appreciation.
Europe growth has been very strong - and the FX market has responded accordingly. This is a bit of a question mark for me - interest rate futures' pricing is hovering around record lows for a ECB rate hike by June 2018.
If we get some convergence there, that would mean Euro sells off a bit - helping dollar bounce - but in terms of the intricacies of the ECB at this point in time? *Shrug*
Now the rest of the world. The most dollar sensitive countries are obviously in EM. Many of the Asian countries have already shown signs of intervention against their strengthening currencies as they start to accumulate reserves, specifically in dollars.
Exhibits below for your entertainment:
Eventually, dollar shorts should notice. Again, I've noticed in the past that these trades in these currencies often preceded moves in US rates. Canary number two for the aviary, anyone?
By the way, shout out to fellow contributor Shawn who shared an article articulating what is beginning to transpire across the world - you can read all about it via the link below.
https://www.cfr.org/blog/few-words-dollar
6) The Donald and the Fed are changing quickly. Stanley Fischer is gone. Uber-liberal Brainard will probably follow. Who's Trump going to nominate? Probably Republican-type candidates - guess what? They are usually more likely to be hawkish than dovish.
To me, that in itself is compelling thought. What can potentially make it more compelling? Well, the Donald seems to have started working well with Democrats as of late. Let's project that further - if they can manage to pull together a deal for tax reform, even if it's not super impactful, it will be symbolic.
It will symbolize that Donald can get things done - I would think the rates markets would immediately do a 180 and return to the post-election regime. Yes, I am projecting here, but think about the risk reward of your positioning at this point. Should the rates go higher or lower? Should dollar go higher or lower?
If he does pass through tax reform. What's next? Tariffs? Additional government spending? Again, just projecting here...Inflation?!?! *Gasp*
7) Lucky number 7. I'm big on sentiment - from the eye test, I think people are pretty close to limit short USD at this point. Just a hunch.
Hey! It's free blog okay? Take it or leave it! :)
Are there catalysts?
I hate catalysts.
It's been a lonnnnngggg post, please bear with me a little bit longer. A lot of what I have detailed are projections - but that's macro trading to me - you have to anticipate in order to correctly speculate. Maybe that's why I'm often a little bit early on these things. Hmmmm.
But often your returns and risk-reward decay swiftly if you wait for a clear catalyst to materialize. So... in my opinion, proceeding with some caution is probably better than proceeding before it's too late.
General House Cleaning:
Stocks short - Yeah threw in the towel like Mcgregor on August 29th. Geopolitic risk is definitely subsiding. Let me explain.
It's not that there can't be another crazy development tomorrow. But the market is just not ready to go down just yet - traders should know what I'm talking about. My Ah ha! moment was when North Korea launched their "hydrogen bomb".
Along with the hurricane, the market was confronted with a copious amount of "bad" news. Equities gapped down, but by the end of the day, it actually covered the gap and closed higher!
Disgusting, I know. But looks like the indexers and VIX carry monkeys will get to make money for a while longer.
EM equities - this has been an impressive move. I believe this is a multi-year trend when I detailed it long ago.
With that in mind, it has run up a lot. If the dollar does bounce, we are probably going to get a shake out of the weak hands and late comers to the trade.
Cocoa and sugar - both bottoming nicely. I still maintain sugar might be a tad too early. Cocoa looks really good and I strongly believe it can rip. I even did some work to do a seasonality adjustment. Below is the inverse inventory on a seasonally adjusted basis vs price. Please excuse the poorly drawn arrows.
Anyways, have a good week guys.
176 comments
Click here for comments